MF ails June 26, 2012 at 3:34 pm

A few of my favourite quotes from the trustees’ report into the failure of MF Global. First, strategy:

Regardless of whether Mr. Corzine’s bet on European sovereign debt would ultimately have been profitable, in the short term, MF Global became increasingly vulnerable to the developments that ensued in the fall of 2011… As MF Global’s liquidity needs intensified, senior management looked increasingly to the FCM as a source of liquidity for the non-FCM business… [and they] were well aware that excess funds from the FCM were being used to fund the non-FCM side of the business on an on-going basis.

Next, segregation:

the regulations for Customer Segregated accounts require a daily accounting of the net liquidation value of the customer funds in the account (the “Net Liquidating Method”). CFTC regulations, however, did not require that all customer funds necessarily be maintained on a dollar-by-dollar basis in the Foreign Secured accounts. Instead, unlike Customer Segregated accounts (for trades on domestic exchanges), the CFTC regulations allowed an “Alternative Method” for calculating whether Foreign Secured accounts were in regulatory compliance even though less than all customer funds deposited for trading on foreign exchanges might actually be deposited in Foreign Secured accounts. MFGI used this “Alternative Method,” and during the month of October 2011, the amount of “Regulatory Excess” — the average amount of customer funds in excess of the regulatory requirement under the Alternative Method (but not the Net Liquidating Method) — was approximately $1 billion. Some at MF Global considered the Regulatory Excess to be a potential source of funds for intraday, or even overnight, transfers to fund the non-FCM activities of MF Global, although others were of the view that the Regulatory Excess would still have to be “locked up” for the benefit of customers. Finally, since the CFTC required that the calculations be done “as of the close of business each day,” questions existed as to whether funds needed to be “locked up” for the benefit of customers intraday as well.

Intra-day vs. end of day compliance with segregation rules:

When MF Global’s proprietary trading gave rise to a need for additional liquidity, Operations in New York would request what they referred to colloquially as an intraday “loan” … from the Treasury Department in Chicago. The Customer Segregated or Foreign Secured accounts at the FCM were at times tapped to fund these transfers. Because compliance with the CFTC regulations was computed as of the close of business, as long as the transfers were returned before the end of each day, some MFGI employees did not consider the transfers to have any regulatory implications, although the CFTC has stated that FCMs must be in regulatory compliance at all times.

The immediate failure: loss of confidence combined with liquidity risk (and with just a soupcon of operational risk for extra piquancy):

S&P put MF Global on “Credit Watch Negative,” and on October 27, Moody’s cut MF Global to junk status… A classic run on the bank ensued as customers sought to withdraw their property from their MFGI accounts, while counterparties and exchanges demanded increased collateral or margin. At the same time, other counterparties declined to do business with MF Global altogether, leaving it with illiquid securities that it could not finance in the repo market or elsewhere. The rush to meet funding needs for collateral, margin and customer liquidations led to billions of dollars in securities sales, draws on credit facilities, and a web of inter-company transactions across MF Global affiliates. MF Global’s computer systems and employees had difficulty keeping up with the unprecedented volume of transactions. Some transactions were recorded erroneously or not at all. So-called “fail” transactions, where either the buyer or seller failed to deliver the cash or the security, respectively, were more than five times greater than the normal volume that week. It was, in the words of one former MF Global executive, a “liquidity asphyxiation.”

Repo counterparties demanded extra haircuts as the crisis deepened;

the cash created within the repo matched book began to decline because counterparties demanded greater haircuts on the collateral that MFGI posted

LCH, and other clearing houses and settlement bodies, also had a role in intensifying the liquidity stress in the final days:

During the final week, LCH and FICC, among others, increased their margin requirements

And, of course, BNYM and JPM were key players as MF’s clearing banks.

However, and this is crucial, “Had customer funds been properly protected, the customer property in Customer Accounts should have been largely if not completely unaffected by the liquidity crisis at MF Global. Instead, these funds were used to fund MF Global’s liquidity needs.”

CME’s role in overseeing compliance, including compliance with segregation rules:

In addition to being a DCO, the CME was also MFGI’s DSRO. As MFGI’s DSRO, the CME was charged with supervising MFGI’s compliance with the financial and reporting requirements of the CEA and relevant CFTC regulations.

Looser segregation is possible under English law, but clients have to opt in to it:

Under English law, while money and other assets belonging to a client but held by an FSA-authorized investment firm must generally be segregated… certain
types of clients can agree to alternative arrangements which potentially afford lesser protection in the event of insolvency. Specifically, certain customers may consent to absolute title transfer of that customer’s assets to the FSA-authorized investment firm under a “title transfer collateral arrangement”

Key recommendations:

  • Abolish The Alternative Calculation Method [for determining seg amounts] And Implement A Required Excess “Cushion”
  • Eliminate The Segregated vs. Secured Distinction … [and] Ensure Consistency of Customer Protection When Trading Overseas, And Closely Monitor Compliance Abroad
  • Create A Protection Fund For Futures And Commodities Customers Under A Certain Threshold, And Implement Suitability Standards For FCM Customers
  • Provide For Civil Liability For Officers And Directors In The Event of Commodities Segregation Shortfall
  • Simplify CFTC Rules For Bulk Transfers And Claims In An FCM Liquidation Proceeding

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